Frugality Pays with Target-Date Funds

When selecting a target-date fund, don't overlook expenses.

That's a take-home message from Morningstar's forthcoming Target Date Series Ratings and Reports. We've made price a key component in our rating system for target-date series because over the many years that an investor will likely hold a target-date fund, the compounding advantage of lower expenses can add up to a sizable effect on that investor's nest egg at retirement.

In our target-date series ratings and reports, which are due out in September, we've found a dramatic range of expenses among the 40 target-date fund families that qualify for our universe. The difference between the cheapest and most expensive target-date series amounted to more than 120 basis points annually. That's a huge disparity that any discerning investor (or prudent fiduciary) should closely scrutinize.

Zeroing In on Target-Date Expenses
Figuring out the right approach to target-date expenses is tricky. For one thing, we wanted to look at overall expenses across a target-date series, not just the expenses of single target-date funds. In addition, because target-date funds are predominantly distributed in employer-sponsored retirement plans, there are a multitude of retirement share classes aimed at different plan sizes and different levels of service, not all of which are directly comparable from one fund series to the next. Finally, because most target-date funds operate as fund of fund structures, it's important to ensure that the expense calculations properly wrap up all of the underlying fees.

We begin by pulling out the net prospectus expense ratio for each fund in a target-date lineup. (For a fund of funds, this is the figure that most accurately shows what the firm is charging investors, net of any waivers.) Then we identify the lowest-cost share class in the lineup that holds at least 10% of total assets in the series. Why do we include this caveat? It might be simpler to just select the cheapest share class, but it would be less representative of investors' realities. We have found, for instance, that in some cases, the funds' lowest-cost institutional share class holds a tiny fraction of the overall assets in a target-date fund series. Finally, we average the expense ratio for the selected share class across all the funds in the lineup to get an overall average for the fund series.

Surprise, Surprise: Indexes Are Cheaper
We ended up with a target-date universe of 34 families, all of which have at least 18 months of performance history. The differences in expenses are most notable at the extremes. The Vanguard Target Retirement Series, with an overall expense ratio of just 0.19%, is 80% lower than the industry average of 0.90%. The Vanguard target-date funds, built on a foundation of its low-cost index funds, are much less expensive than even the next closest index funds from Nationwide (0.65%) and Wells Fargo (0.67%), whose fund expenses do rank favorably compared with the target-date universe as a whole. While passive structures generally correspond with lower costs, there are some exceptions. The Seligman TargetHorizon ETF series, for example, is one of the most expensive target-date series (with a 1.20% average), indexed or actively managed, even though the series' underlying ETFs have low expense ratios.

Among actively managed offerings, American Century Livestrong is the cheapest option with a 0.67% expense ratio, on par with the indexed series from Wells Fargo. Bunched closely behind are TIAA-CREF Lifecycle, T. Rowe Price Retirement, and Fidelity Freedom. With the exception of TIAA-CREF, all these fund families have eliminated the so-called overlay fee, a management fee that sits over the fees on the underlying funds, common among target-date funds. At the other end of the scale, the most expensive target-date offerings are run by advisor-sold fund families Franklin Templeton (1.27%) and Oppenheimer (1.44%). The cost structures may be inherently higher at firms like these that sell into the smaller-plan market through advisors, but the broker-sold American Funds series charges just 0.71% for its A shares, so clearly the Franklin and Oppenheimer shares could be much more cheaply priced.

Some Series Cutting Fees
Expenses are likely to fall as competition among target-date funds increases and companies seek new ways to keep costs down. The Schwab Target Series, for example, recently announced cost cuts to its funds, achieved through a combination of eliminating its overlay fee and adding index funds to its underlying investment mix. Other fund groups, such as John Hancock, mix index and active funds to help rein in costs. Putnam and Principal have also recently announced lower expense structures.

This expense trend is positive, but we'd be watchful for waivers. These temporary fee cuts are common among target-date series. They're only temporary, and there's no guarantee that the waivers will continue. The Vantagepoint funds, for instance, saw their expense ratio rise by 10 basis points in mid-2009 when the fund board voted not to renew a waiver.

The Bottom Line
Expenses may not be the first thing to look at when choosing a target-date fund, but they certainly shouldn't be the last. Target-date funds can offer a good deal to investors, as many funds charge investors less than the sum of the underlying funds. Getting locked into a cheap target-date fund can pay big dividends over the long term. Conversely, sign up with one of the pricey options, and you'll be paying those extra fees for years--perhaps decades--to come. To take a simple example, say you're 25 years old and invest $5,000 in a target-date 2050 fund this year, add $3,000 to the account each subsequent year, and the fund earns a 6% compound annualized return over the next 40 years. At that point, you'd have a nest egg of $549,657. But invest in a different fund that earns the same total return but charges 50 basis points more in expenses per year, and you'd end up with $480,264--a full $69,000 less.

For retail investors searching for a target-date fund, it probably makes sense to start with the lowest-cost funds on our list, then look for other characteristics you favor. Plan sponsors and those serving them should make costs a key criterion when doing their due diligence. For retirement-plan investors limited to the target-date offering in a 401(k) plan, see how your fund sizes up: If it's on the expensive side, at least you'll have the information to make some noise about it with your plan administrator, and you can always look for other, cheaper options within your plan.

Looking for more information on target-date funds? Later this quarter, Morningstar will be releasing its Target-Date Series Ratings and Reports on 20 top fund series. The reports will be available to Morningstar.com's Premium subscribers as well as to Principia Mutual Fund Advanced, Morningstar Workstation Office Edition, Morningstar Workstation Enterprise Edition, and Morningstar Direct subscribers.